Executive Remuneration and the Two Strikes Rule - Case Study Example

Running Head: Ехесutivе Rеmunеrаtiоn and the “Тwо Strikеs” Rule Name Course Lecturer Date Ехесutivе Rеmunеrаtiоn and the “Тwо Strikеs” Rule The “Тwо Strikеs” Rule There has been controversy in executive compensation since the 1990s. Executive remuneration has also come under substantial media scrutiny. There has been public anger towards executive compensation especially since the advent of the global financial crisis. With an apparent objective to restrain executive compensation, Australia introduced new legislation known as Corporations Amendment (Improving Accountability on Director and Executive Remuneration) Act 2011. This “say on pay” legislation was introduced in 2011, it is commonly known as ‘two strikes’ rule (Monem & Ng, 2013). The purpose of this legislation is to improve accountability of executive remuneration. This legislation provide that if an entity receives 25% or more dissent votes for two consecutive years (commonly known as the ‘two strikes’ rule), the entity’s board of directors, except the chief executive officer, is likely to face re-election (Pick, 2011). This is a massive voting power awarded to an entity’s shareholders of Australian entities. Previously, the shareholders the shareholders voting on executive remuneration report had no specific predictable consequences (Matolcsy & Wright, 2011). Currently, the Corporations Act 2001 requires a listed entity to put forward its remuneration report to a non-binding shareholder vote at the general meeting (O'Hara, 2013). Nevertheless, the Corporations Act does not set out any consequences where an entity's boards proceed with its remuneration policies irrespective of the shareholders concerns or vote. The Corporations Amendment Act 2011 shareholder involvement, through the act, the shareholders concerns are addressed before the remuneration report is adopted (MacMillan, 2012). Since its inception in 2011, this ‘two strikes’ rule or the Remuneration Amendment Act (as it is known in the amendment) has come under heavy criticism from corporate managers in Australia. The rule ties the remuneration of the executives with their performance (pay-performance). This performance of the executives in corporations is expected to improve after the introduction of this rule. This rule has just reached its second year application. The amendment also made changes not only to the executive remuneration but also board limits as well as determination of when a proxy votes (Corporations Amendment Bill 2011). The directors of an entity are held responsible and accountable for the executive salaries and bonuses. This means that an entire entity board can face re-election if the shareholders disagree with how much executives are being paid. Moreover, the rule requires entities to put forward a motion to the shareholders to “spill” the board if the remuneration report receives a ‘no’ vote of 25% or more at two consecutive annual general meetings (Athanasoff & Secrett, 2011). This legislation was introduced on the back of recommendations made in the Productivity Commission’s “2009 Report on Executive Remuneration” (Australian Government Productivity Commission, 2009). It also aims to address investor and public concerns about executive remuneration by way of providing greater accountability to investors in an entity around what the executives are paid (Vickovich, 2013). Maureen McGrath, a general counsel asserted that “shareholders would sometimes vote against a remuneration report even after meetings with the chairperson of the remuneration committee (Anderson, Gahan, Mitchell & Ramsey, 2012). The reason for this is that the shareholders may have different objectives to the entity or they may be under mandate to follow foreign governance guidelines that do not exactly align with practices in Australia or Australian policies. ” For the three years the rule has been in application, it has obviously frustrated several boards of directors throughout Australia. On a positive note, it has highlighted the significance of a proactive board as well as active and regular shareholder engagement in setting executive remuneration (Byrne, 2012). Also, there are many more entities improving their accountability and communications to their shareholders about remuneration after getting a first strike. However, the spill and re-election course obligated by the ‘two strikes’ legislation is uncommon occasion in the country as the shareholders are still in the dark about the rule (shareholders are gaining information about the rule). Essentially, the introduction of “two strikes” rule in 2011 has fairly enabled more active shareholder involvement in the setting of executive remuneration. It has also improved the accountability of directors for decisions regarding remuneration in listed entities (Kulich et al., 2011). Disclosure of Executive Remuneration in Australia Listed entities in Australia are subject to some of the sternest disclosure requirements in relative to remuneration of executives in the world. Objective data indicates that Australian entities have generally strong performance. Despite this indication, there is increasing momentum about excessive amounts paid to relatively small number of executives as compared with the average earnings (Matolcsy & Wright, 2011). Before the introduction of the “two strikes” rule, there were cases where executive pay was not linked to performance especially in the area of termination payments (executives moved before their contracts were finished). There has been an increasing trend of the number of Australian investing directly in the stock market as indicated by the Australian securities exchange (ASX). The investors were having very high expectations of high investment returns, however, this was not sustained and hence the investors became disillusioned. As such, shareholders in Australia, with a growing expectation of greater regulation of entities to reduce the risk of investing, proposed stern legislation (Li, Henry & Chou, 2011). The reforms made earlier in 2004, required listed entities to disclose the remuneration of the directors as well as the highest paid executives in the remuneration report. It provided that the report to be accompanied with explanations of the proportion of remuneration that was performance based. The 2004 reforms also introduced a requirement for entities to place a resolution to its shareholders at the AGM that the remuneration report be adopted as spelt out in section 250R of the Corporations Act (Handicott, 2013). However, the vote was advisory only and did not bind the company directors or the entity. This reform also intended to focus attention on executive remuneration as well as encourage entities to come clear and explain remuneration decisions and also address the concerns of the shareholders. There were no consequences for failure to do so apart from the discontentment of the shareholders and likely adverse public comment (Monem & Ng, 2013). There was need for a strong regulatory structure after the global financial crisis, the regulatory authority considered the significance of ensuring suitable constituting of the remuneration package in order to stimulate accountability and transparency in remuneration practices especially for listed entities. The investors’ concerns increased due to massive lose in stock value arising from the financial crisis (Orsagh, 2012). This made the government to set up the Productivity Commission in 2009 to research on a range of social, economic and environmental issues for inquiring in to the effectiveness and efficiency of the current structure for accountability, oversight and transparency of remuneration practices in Australia as well as to make recommendations of how the current structure could be reinforced. The Corporations Amendment Act 2011 or the “two strikes” rule was one of the recommendations and was implemented in 2011 (Athanasoff & Secrett, 2011). Shareholder Involvement in the Setting of Executive Remuneration Before the introduction of the “two strikes” legislation, the shareholders had no say on the executive remuneration. After the introduction of the rule, entities are supposed to disclose remuneration package, use of remuneration advisers, and entities to institute remuneration committees as well as hedging of performance related remuneration. This gave the shareholders power to have their say on the remuneration of the executives through voting of the proposed packages (Conyon, 2011). In addition, shareholders have to ratify new board appointments; entities are also subject to board rotation requirements giving the shareholders change to vet new appointments. The directors cannot hold office for more than three years without the shareholders’ approval. These are a range of powers given to shareholders concerning the remuneration and performance of executives. This reverses the tradition where by the board had the responsibility for engaging and remuneration management. This range of measures indicates that rule has facilitated more shareholder involvement in setting of executive remuneration (Anderson, Gahan, Mitchell & Ramsey, 2012). Moreover, the reforms also ensure that the remuneration decisions are based on independent review and independent advice by the remuneration committee and they are suitably and plainly disclosed in the remuneration report. The remuneration committee is independent and hence gives professional advice on the remuneration of the executives. This requirement was not there in the previous legislations but was introduced in the “two strike” rule to give the shareholders direction and advice on the remuneration of executives based on their performance (Kulich et al., 2011). This rule raises potential opportunity for reconstitution of the board if the shareholders reject the remuneration package. If the shareholders are not satisfied with the remuneration package, they can vote no in two consecutive general meetings. This will made the company to reconstitute the board by removing the directors whose remuneration package has been rejected by the shareholders (Li, Henry & Chou, 2011). However, this rule attracts unwarranted consequence that result to disruptions and costs for entities especially those with the likelihood of a spill meeting thereby resulting to practical changes (Robin, 2012). This rule has increased the administrative burden and costs of convening any annual general meeting. This is because, it is necessary to include the impacts and consequences of the “two strikes” rule as well as the details of the applicable voting exclusions. Entities that have received this rule keenly (more so the entities that have already fallen victim of this rule) have added requirement to include and provide explanations of conditional spill resolution, the entity will have to put this resolution to the vote in the event of a second strike (MacMillan, 2012). This indicates that entities are becoming very cautious as the shareholders have to evaluate the performance of the executives. Entities also have a practical need to engage with the shareholders to greater extents than usual in order to encourage representative votes. The cost of conducting a poll, where required to determine plainly the result of voting on remuneration related resolutions is also possible to be substantial. Although it is costly and disruptive, this facilitates the involvement of shareholders in determining executive remuneration (Athanasoff & Secrett, 2011). The results of annual general meetings for entities facing a second strike, in the last two years since the introduction of the rule, as well as successive meetings will be very beneficial in contemplating whether the existing consequences of second strike are suitable or whether there is need to deliberate alternative consequences. Conversely, if the spill meetings are uncommon or they are of little effect, then the risk of a spill may be viewed as adequate motivation to deliver the level of transparency and accountability designed for in the rule (Hill, 2011). By 1st February 2013, a total of twenty one entities had already received a second strike while five entities (out of the twenty one) were required to hold a spill meeting. In one of these fives entities, the directors affected resigned thereby removing the need for a spill meeting. From 1st February there has only been one spill meeting, the directors, required to present them for re-election were persuasively re-elected. The second strikes, the spill meetings, resignation of directors and the re-election indicate the involvement of shareholders in setting remuneration package for the executives. This is as a result of the rule; it has facilitated their involvement in setting remuneration (MacMillan, 2012). According to the Remuneration Amendment Act, once an entity receives the first strike, it is critical and imperative for the entity to address the concerns of the shareholders. This is because the rule requires the board to explain to the shareholders in the next general meeting how it addressed shareholder concerns over the remuneration report (Bugeja et al., 2012). If the entity does not address the shareholder concerns adequately, it is highly likely that the entity would face a second strike thereby leading to a spill motion as well as subsequent dissolution of the board of directors except the CEO. As such, it is possible that when an entity the first strike, the board takes actions including compelling pay cuts or even making a larger percentage of the remuneration performance-based or “at risk”. Shareholders dissent makes an entity to align the executive pay with performance. This is clear evidence that the introduction of the rule has facilitated more active shareholder involvement in setting executive remuneration (Conyon et al., 2011). When there is separation of ownership and control (like many listed entities), there exists a principal-agent relationship between the CEO as the manager and the shareholders as the owners. The major challenge for the principles in this relationship is to design a remuneration package that induce utility-maximising, self-interested, risk averse agent to act in the best interests of the principals as they aim to maximise the performance and value of the entity (Bugeja et al., 2012). Because the objective of the “two strikes” rule is to improve accountability and reinforce the non-binding vote, it is very likely that rational shareholders reflect on the level of wealth generated by the directors while voting on the executive remuneration. The directors have responsibility of creating wealth for shareholders while the wealth is affected by the entity’s performance. As such, shareholders view the entity’s performance as a function of executive determinations. For this they want to directly link the performance with the pay (MacMillan, 2012). Entities are increasingly reviewing their executive remuneration policies in the wake of the rule. Most firms do not want to the shareholders to strike in the future and hence pay particular attention to improving the executive pay-performance link (Australian Government, 2011). Notably, the absences of the CEO in the remuneration committee as well as the independence of the committee chairperson are significant in gaining shareholders confidence that the executives are not engaged in self-dealing behaviour. The fact that the shareholders have to approve the remuneration committees’ report indicates that the shareholders are not only involved in setting but also control of the remuneration package of the executives (Monem & Ng, 2013). Although the shareholders do not set the pay for the executives, they determine the package Although the rule facilitate the involvement of shareholders, their ability to influence the results of the remuneration report resolve might possibly be used for drives other than to express disquiets about remuneration only. That ability may afford the influence for the shareholders to effect a board spill for some other unrelated reasons to remunerations or even pursue to discuss other consequences with the board (Conyon et al., 2011). This does not improve the accountability of directors for decisions regarding remuneration in listed entities. The shareholders may be driven by such cause as witch hunt, malice and hate to push for the spill. This makes the rule not successful in its aims and purpose for which it was introduced for. As such, it is important for entities and the shareholders to practice honesty and professionalism while reviewing and setting executive remuneration (Hill, 2011). Conclusion There has been growing concerns in Australia over “excessive” executive remuneration over the last twenty years. The Australian government and the regulatory authorities have been under massive pressure to take the appropriate measures to reign in executive remuneration. In 2009, the Australian government formed a commission to research on the effectiveness and efficiency of the current structure for accountability, oversight and transparency of remuneration practices in Australia and to provide recommendations thereon. The Australian government introduced new legislation in 2011 for regulating executive remuneration; this legislation is known as the “two strikes” rule. Under the rule, if an entity receives at least 25 percent ‘no’ votes on remuneration report in two consecutive years, the entity should provide for a spill motion to disband the current board and re-elect a new board. In this report, the researcher discussed how the “two strikes” rule facilitates more shareholder involvement in setting of executive remuneration. The researcher also discussed how the rule has improved the accountability of directors for decisions regarding remuneration in listed entities. In evaluating how the rule facilitates shareholder involvement, the researcher indicates how shareholders exercise this new power. It indicates how voting by the shareholders makes an entity to review and structure executive pay based on the performance of the directors. It also indicates that the shareholders may over react in exercising their voting influence as they may be driven by other factors other than executive remuneration to make directors to resign. Essentially, this report provides evidence on the effectiveness of the three year old rule on executive remuneration. Since the introduction of the rule in 2011, the pay-performance link has not only improved but also has increased shareholder involvement in setting executive remuneration. References Anderson, H., Gahan, P., Mitchell, R., & Ramsey, I., (2012). Investor and worker protection in Australia: A longitudinal analysis. Sydney L. Rev., 34, 573. Athanasoff, J., & Secrett, B., (2011). Executive Remuneration Legislation-Empowering Shareholders or Burdening Companies?. Keeping good companies, 63(3), 132 Australian Government Productivity Commission, (2009) Executive Remuneration in Australia, Productivity Commission Inquiry Report No 49, Melbourne. Australian Government, (2011). Corporations amendment (improving accountability on director and executive remuneration) act 2011, No, 42, Canberra. Bugeja, M., da Silva Rosa, R., Duong, L., & Izan, H., Y, (2012). CEO compensation from M&As in Australia: Journal of Business Finance & Accounting, 39(9‐10), 1298-1329. Byrne, A. (2012, December 22). ‘Two strikes’ rule hits the mark. Retrieved September 2014, from Financial Review: http://www.misaustralia.com.au/p/opinion/two_strikes_rule_hits_the_mark_vr6Ix5bAalbwYrIfToSYyM Conyon, M., J., (2011). Executive compensation consultants and CEO pay.Vand, L. Rev., 64, 397. Conyon, M., J., Fernandes, N., Ferreira, M., A., Matos, P., & Murphy, K., J., (2011). The executive compensation controversy: A transatlantic analysis. Corporations Amendment (Improving Accountability On Director And Executive Remuneration) Bill 2011. (2011). Retrieved September 2014, from Commonwealth of Australia Explanatory Memoranda: http://www.austlii.edu.au/au/legis/cth/bill_em/caaodaerb2011890/memo_3.html Handicott, T. (2013, February 1). Executive pay and the "two strikes rule": is board stability at risk in Australia? Retrieved September 9, 2014, from Practical Law: http://us.practicallaw.com/1-522-8733?q=&qp=&qo=&qe= Hill, J., G., (2011). Regulating executive remuneration after the global financial crisis: common law perspectives: research handbook on executive pay, J. Hill and R. Thomas, eds., Forthcoming. Kulich, C., Trojanowski, G., Ryan, M., K., Alexander Haslam, S., & Renneboog, L., D., (2011). Who gets the carrot and who gets the stick? Evidence of gender disparities in executive remuneration: Strategic Management Journal, 32(3), 301-321. Li, H., Henry, D., & Chou, H. I., (2011). Stock market mispricing, executive compensation and corporate Investment: Evidence from Australia. Journal of Behavioral Finance, 12(3), 131-140. MacMillan, C. (2012). Corporate law: Impact of regulatory reforms on executive remuneration in Australia-AGMs in 2011, Keeping Good Companies, 64(2), 100. Matolcsy, Z., & Wright, A., (2011). CEO compensation structure and firm performance: Accounting & Finance, 51(3), 745-763. Monem, R., & Ng, C., (2013). Australia’s ‘two-strikes’ rule and the pay-performance link: Are shareholders judicious?. Journal of Contemporary Accounting & Economics, 9(2), 237-254. O'Hara, A. (2013). Retrieved 2014, from Coors Chambers Westgarth Lawyers: http://www.corrs.com.au/thinking/insights/executive-remuneration-results-of-spill-meetings-put-effectiveness-of-two-strikes-in-question/ Orsagh, M. (2012, September 26). “Say on Pay” in Australia: Two Strikes and You’re Out. Retrieved September 9, 2014, from CFA Institute: http://blogs.cfainstitute.org/marketintegrity/2012/09/26/say-on-pay-in-australia-two-strikes-and-youre-out/ Robert Pick. (2011). Focus: 'Two-Strikes' Rule Part Of Executive Remuneration Shake-Up. Retrieved September 2014, from Corporate Governance: http://www.allens.com.au/pubs/cg/focgjun11.htm Robin, M. (2012). How the two-strike rule became a big stick. Retrieved September 9, 2014, from Smart Company: http://www.smartcompany.com.au/growth/innovation/39071-how-the-two-strike-rule-became-a-big-stick.html# Vickovich, A. (2013). investor daily. Retrieved September 2014, from Two-strike rule has improved corporate governance: http://www.investordaily.com.au/21835-two-strike-rule-has-improved-corporate-governance Read More